macroeconomic equilibrium in the short run

Macroeconomic equilibrium

in the short run

The big picture

Introduction

IS-TR today and Monday

IS-TR with capital flows: Wednesday

AS-AD: lecture notes (+ parts of Ch 13)

AS: Ch 12

TR curve

IS- TR

Model

Outline

1. Cyclical fluctuations

2. Short versus long run

3. Determinants of aggregate demand

4. The Keynesian Cross

1. Equilibrium of demand and supply

2. The Keynesian demand multiplier

5. The IS curve

Fluctuations in real GDP growth (US)

Mankiw: Macroeconomics, Seventh Edition

Growth rates of real GDP, consumption, investment

-30

-20

-10

0

10

20

30

40

1970 1975 1980 1985 1990 1995 2000 2005 2010

Percent

change

from 4

quarters

earlier

Investment growth rate

Real GDP growth rate

Consumption growth rate

Cyclical Fluctuations

How can we explain these cyclical deviations?

Is it possible to reduce them?

Time

Rea

l G

DP

Long-term growth trend

Actual real GDP

(-) cyclical deviation

(+) cyclical deviation

Short versus long run

Classical dichotomy holds only when prices are flexible

Prices can be considered flexible in the long run, but are “sticky” in the short run

Goods

Market

Money

Market

Interest rates affect

aggregate demand

Income influences

demand for money

Flexible prices =

Money neutrality

Sticky prices ≠

Money neutrality

How realistic are sticky prices?

Mankiw: Macroeconomics, Seventh Edition

Aggregate demand and aggregate supply

Classics long run

Prices are flexible

Aggregate supply (K, L, A) determines income Prices adjust aggregate demand = aggregate supply

Keynes short run

Assumption of sticky prices

Aggregate demand determines output of firms

Prices cannot adjust aggregate demand can differ from supply supply adjusts to demand

Who is right? Both! AD-AS Model accommodates the two different views in one

Aggregate demand

Today

We start to develop the IS-TR model, the basis of the aggregate demand curve

AD curve: Relation between quantity of output demanded and the aggregate price level (Chapter 13)

We focus on the short run and assume the price level is fixed

Outline

1) What is the aggregate demand?

2) Show how we find the equilibrium between aggregate demand and supply of goods

Aggregate demand and the goods market

What is aggregate demand?

Y = C + I + G + X - Z

Aggregate supply

Total volume of goods and services brought to the market by producers at a given price level

Aggregate demand

Sum of planned consumption, investment, government purchases of goods and services plus net exports of goods and services PCA: primary current account=net exports of goods and services (X-Z)

Aggregate

supply

Aggregate

Demand

Actual versus desired expenditure

Y = actual income (or actual output, expenditure)

Production, supply of goods

DD= desired or planned expenditure (C+G+I+PCA)

What amount the economic agents would like to spend given their income Y (level of GDP ) and given that the price level is fixed

Equilibrium

Actual expenditure = desired expenditure

Y = DD

When firms have sold all their output and people were able to buy everything they planned

Actual versus desired expenditure Why can Y (supply/income) and DD (demand) differ?

Y >DD: Firms did not sell us much as they expected at the given price level.

At the end of the year, they have to buy the rest of their products unplanned increase of investment in inventory

Actual I > planned I (actual expenditure > planned expenditure)

Y <DD: Firms sold more then they had planned because of an unexpected high

demand from the households unplanned decrease of investment in inventory

Actual I< planned I

Study graphically the link between income (Y) and DD 1. Components of the aggregate demand (DD)

2. Keynesian Cross

The components of aggregate demand

Closed economy: link between DD and Y?

Aggregate demand (DD) = C + G + I

G: public expenditure (assumed exogenous)

I=I(i, q) Chapter 8

i : (real) interest rate (-)

q:Tobin’s q, (measure of entrepreneur’s expectations about the future) (+)

C=C(Ω, Y-T) Chapter 8

Ω: wealth, assumed exogenous (+)

Y-T: disposable income. T=exogenous (+)

Desired demand

Income (Y)

Desired d

em

and

DD

0

varies

Ceteris paribus

(Exogenous variables)

(+)

Demand

The higher my income,

the higher my desired

demand

Slope of the desired demand function

Simple case: closed economy

DD = C + I + G

Slope of DD curve:

Marginal propensity to consume (MPC)

Assumption: People consume a fixed proportion c of income, MPC = c

Income

Desired d

em

and

DD

0

When Y : Consumption , but less than Y DD

ΔC=cΔY ΔC < ΔY

Example: c=0.6, ΔY=10 ΔC=10*0.6=6

ΔY

ΔC

The components of aggregate demand Open economy:

Adding imports and exports (primary current account).

What is aggregate demand for domestic goods and

services?

Aggregate demand (DD) = C + G + I + PCA

PCA =X – Z = Net exports = PCA (Y, Y*, σ)

σ: real exchange rate (-) impacts on our

competitiveness (σ↑ X↓) (exogenous)

Y*: foreign GDP (+) increases our exports (exogenous)

Y: (-) increases our imports

Desired demand

Income (Y)

Desired d

em

and

DD

0

*, , , ,C T I i q G CA YP YDD Y

varies varies

Ceteris paribus

(+) (-)

Question: Is the

desired demand curve

in the open economy

flatter or steeper than

in the closed

economy?

Slope of the desired demand function Open economy:

1. When Y : DD by ΔC=c ΔY (Example: c=0.6, ΔY=10 ΔC=10*0.6=6)

2. When Y : Consumption and thus demand for imports deterioriates PCA DD

z% of every unit of C =imports (Z). ΔZ=zΔC ΔPCA = -ΔZ <0

(Ex: z=0.4, ΔZ=0.4*6=2.4 ΔPCA=-2.4)

Total: When Y DD increases by a lower proportion that’s why the DD schedule is flatter than the 45° line

ΔDD=ΔC–zΔC =(1–z)cΔY; slope is given by MPC = (1 – z)c

(Ex: 6 –2.4= (1- 0.4)0.6*10=3.6), MPC = (1-0.4)*0.6= 0.36

*, , , ,C T I i q G CA YP YDD Y

Demand and supply

Income

De

sire

d d

em

an

d

DD

0

Supply

Demand

Actu

al outp

ut

Y = DD 45°

The equilibrium condition

Equilibrium at the intersection of the two lines

Desired d

em

and,

actu

al outp

ut

0

equilibrium inthe goods market i.e. =0 Y

DD Y

excess supply of goods

DD Y

0Y

Income

DD

Y ́Y

Supply adjusts

to demand

C

D

45°

The 45° Diagram, a.k.a. “The Keynesian Cross”

At A, actual output equals desired demand D

esired

dem

and

0

DD

Y

Y

*

, ,

, ,

Y C Y T I i q

G PCA Y Y

A

Output, income

Point A:

goods market

equilibrium

45°

The Keynesian demand multiplier

Consider the effects of an exogenous increase in public expenditure.

What will be its effect on aggregate income?

1. Increase in desired demand (planned expenditures)

2. Output (and income) will follow and raise also

Effect on actual output is going to be bigger than just the direct effect on demand brought about by the

increase in public expenditure: ΔY > ΔG

*

´

´ , , , ,

G

DD C Y T I q r G G PCA Y Y


D

esired d

em

and

Y

DD

45°

DD(Y)

A

Output 0


Output

Desired d

em

and

Y

45°

DD (́Y)

A DD1

DD(Y)

Government

expenditures

increase

Output 0

G

B DD2

*

´

´ , , , ,

G

DD C Y T I q r G G PCA Y Y

B


Output increases to match increase in demand

Output

Desired d

em

and

A

Y

Y

45°

A ́ DD(Y)

DD (́Y)

Output 0

G


BA ́increase in income means DD ́increases too

Output

Desired d

em

and

A

Y

Y

45°

B B ́

DD(Y)

DD (́Y)

Output 0

G

A ́


Output increases again to meet induced demand, A B́

Output

Desired d

em

and

Y

Y

45°

B A ́

B ́

DD(Y)

DD (́Y)

A

Output 0

G

A´́

The Keynesian demand multiplier The government spending multiplier

Tells us how much income rises in response to a 1€ increase in G.

Output

Desired d

em

and

A

Y

Y

45°

B A ́

E

Y*

Y

B ́

DD(Y)

DD (́Y)

Y G

Output 0

G We talk about the

multiplier because

ΔY> ΔG:


Keynesian demand multiplier :

The multiplier is bigger…

…the bigger c, the share of my income that I consume

…the lower z, the share of my consumption that I spend on imports Our example: 1/(1-0.6(1-0.4)) = 1.56

This leads to a steeper DD schedule and thus to a higher multiplier

(Why does the multiplier process stop?)

)1(1

1

zc


Output

Desired d

em

and

45°

DD1

Output 0

DD2

Slope of the DD schedule affects the demand multiplier:

Government spending multipliers

one two

Euro area 1.1 1.6

UK 0.8 0.5

USA 1.9 2.2

Belgium 0.9 0.5

Germany 1.2 1.1

Italy 1.0 1.4

Portugal 1.2 1.5

Spain 1.2 1.5

Years after change

IS curve

IS-curve

graphs all combinations of i and Y that result in goods market equilibrium actual output = planned expenditure (desired demand)

downward sloping

So far: we have kept i, and thus planned investment, fixed

Now let’s see what happens to the DD schedule when i varies

Keep in mind: prices are fixed so: i = r !

Key equation: I = I(i)

lower i higher I higher Y

Deriving the IS curve

Identifying an equilibrium combination of i and Y

De

sir

ed

de

ma

nd

Output

Inte

rest ra

te

Output

DD i( )

DD

Y Y

Y=DD

i

A

A

From DD to IS Decrease in i

Equilibrium output will change if the interest rate changes

De

sir

ed

de

ma

nd

Output

Inte

rest ra

te

Output

DD i( )

DD i( )

DD

Y

DD

Y Y Y

Y=DD

i

iB

A

i i

A

B

i

From DD to IS IS curve derived by finding Y’s for all i’s

The lower i the higher the equilibrium output negative slope

Each point on the IS curve represents equilibrium in the goods market.

De

sir

ed

de

ma

nd

Output

Inte

rest ra

te

Output

DD i( )

DD i( )

DD

Y

DD

Y Y Y

A

IS Y=DD

iB

A

i i B

The IS curve D

esir

ed

de

ma

nd

Output

Inte

rest ra

te

Output

DD i( )

DD i( )

DD

Y

DD

Y Y Y

A

IS Y=DD

i

iB

A

Excess

supply of

goods

DD i( )

i

B

D

C

D

C

Excess

demand

of goods

Excess supply and excess demand

Shifting the IS-curve

What shifts the IS curve?

Everything that moves DD will also shift IS except i!

De

sir

ed

de

ma

nd

Output

Inte

rest ra

te

Output

( )DD G,i

A DD

Y

Y=DD

IS

Y

iA

Exogenous and endogenous variables

Exogenous variables Model Endogenous variables

Example IS curve:

ENDOGENOUS variables: those determined by the model.

hint: those on the axes of the graph move on the curve Example IS curve: Y and i

EXOGENOUS variables: all predetermined variables that affect the endogenous variables

hint: NOT on the axes of the graph but in the equation that determines the curve shift the curve Example IS curve: Ω, T, q, G, Y* (overbar variables)

*, , , ,Y C Y T I q i G PCA Y Y

De

sir

ed

de

ma

nd

Output

Inte

rest ra

te

Output

( )DD G ,iB

A

DD

Y Y Y

Y=DD

iA

IS

B ( )DD G,i

DD

Y

Exogenous increase in aggregate demand

For example: increase in G

Exogenous increase in aggregate demand

Similar shift to that from A to B will occur for all other values of the interest rate

De

sir

ed

de

ma

nd

Output

Inte

rest ra

te

Output

( )DD G ,iB

A

DD

Y Y Y

IS ́

Y=DD

iA

IS

B ( )DD G,i

DD

Y

Shifting the IS curve

Any exogenous change in demand leads to a shift of the IS. Various possible sources:

Exogenous change in G

Exogenous changes in expectations on the economy (through Tobin’s q)

Exogenous change in household wealth

Foreign disturbances (Y* and real exchange rate changes)

“More” outward shift, “Less” inward shift

Real exchange rate depreciation outward sift

Boom and bust in USA

90

100

110

120

130

140

150

1/95 1/97 1/99 1/01 1/03 1/05 1/07 0

100

200

300

400

500

600

700

Industrial production Housing prices Nasdaq

Source: See text

macroeconomic equilibrium in the short run

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